Section 2: The Cause of Inflation

In the long run, the value of money, like the price of any good, is determined by the demand and supply of money in circulation. The following example illustrates this concept.

Problem: Let’s say that the nation’s money supply is $1,000 and that during a short, fixed period of time, buyers spend all of this $1,000. Let’s assume that production during this period is 10 units. What will be the average price per unit if all 10 units are purchased during this period?

Solution: The average, equilibrium price will be $100 per unit. If the price is $100 and all 10 units are purchased, then total spending will equal the amount of money in circulation (for simplicity, we will assume that savings are zero). At a higher price, surpluses occur, because buyers don’t have enough money to buy all 10 units. At a lower price, shortages of the product occur. Surpluses and shortages in the long run are not stable. They are corrected through price changes (see also Unit 2). A surplus will make the price come down. A shortage will drive the price up. At equilibrium, the price is stable, unless demand or supply change.

Problem: If the government increases the quantity of money in circulation (the money supply) by $200, then the total amount of available spending during this period of time will increase to $1,200. What will be the average price per unit?

Solution: Assuming no increase in production, the price level will rise to $120 per unit. This equates to an inflation rate of 20%. Assuming a production increase to 11 units, the average price per unit will be 1,200/11 = $109. This equates to an inflation rate of 9% relative to the initial level of $100 (or 8.6%, using the arc formula). As long as the money supply increases by a larger percentage than production, the price level will rise.

Video Explanation
For a video explanation of how increases in the money supply and inflation are related, please visit:

Does an Increase in the Money Supply Stimulate Production?

Many economists and politicians believe that a greater quantity of money in circulation is necessary to stimulate production. The following example illustrates that this is not the case and that production can increase without an increase in the money supply.

What Stimulates Production Increases?

A business that advances its technology and improves its production processes lowers its cost of production and increases its profits.

Critics argue that in the case of a constant money supply, the total revenue of the producers remains the same ($100 times 10 products is the same as $90.90 times 11 products).

An increase in production without an increase in the money supply will lower prices. In the above example, if the money supply remains constant at $1,000 and production increases to 11 products, then the average price per unit is $90.90.

So do the producers really benefit from the technology and production improvement?

When looking at nominal terms, total revenue remains constant, so the answer is no. However, when looking at real terms, the answer is yes. The lower average price level increases the purchasing power of the total revenue. Revenue of $1,000 can buy more if average prices are $90.90 than if average prices are $100.

Short Run versus Long Run

Let’s assume that the government increases the money supply by printing additional money. This additional money allows the federal government to increase its spending, for example on roads and highways. This benefits all road and highway construction workers. Their incomes will increase. Also, interest rates may decrease, as there is more money circulating in our banking system. These two effects stimulate the economy in the short run. However, what happens in the long run, and how are other groups in society affected? The increase in the money supply will decrease the value of money and lower purchasing power of all economic groups. Higher prices on goods and services will make people demand fewer goods and services, and will offset any earlier benefits from the road and highway workers’ increased purchasing power. Inflation also causes uncertainty, mal-investments and higher long-run interest rates, which discourages production and harms the economy in the long run.

Monetary Policy in the United States

Because of the 2008 banking crisis, financial institutions have been much more cautious about making loans. This has slowed down borrowing and spending, and caused a slowdown in real GDP. In an attempt to counter-act this, the Federal Reserve has, until recently, injected large amounts of money into our banking system and into our economy. This may temporarily stimulate the economy. However, when the economy expands again and lending picks up, the money supply will be considerably larger. The concern is that this will create high rates of inflation. Keep in mind that even though not measured in the CPI or PPI, overall inflation includes price increases of assets such as stocks, bonds, land, houses, and other real estate. Considerable increases in the money supply will lead to increases in the prices of these assets. Owners of these assets like that the value of their assets increases and this can provide temporary boosts in economic spending and production. But fast rising asset prices lead to bubbles that burst. This causes serious long term economic problems. as evidenced by the bubble that burst in 2008.

Hyperinflation

If the nation’s money supply is not stable (too much money in circulation), and the value of money decreases (inflation), then people will be more likely to spend it more quickly. If, for example, prices double every week, people will spend their paychecks immediately. If they hold on to their money until the end of the week, prices will be twice as high. This quicker turnover of the money supply equates to an increase in velocity (see a more detailed explanation of this concept in Unit 9) and makes it feel like there is even more money in circulation than there already is. The combination of too much money in circulation and increased velocity often leads to what is called hyperinflation (an extremely high rate of inflation) .

Fortunately, the United States has not experienced hyperinflation. The best known example of hyperinflation is 1923 Germany, when prices doubled every two days and a loaf of bread cost millions of Deutsche Marks. People literally used wheelbarrows to carry money on their way to the bakery. Other examples of countries that experienced hyperinflation include Yugoslavia (1993), Hungary (1945), Chile (1972 – 1974), and Argentina (1989).